I.B.M. Withdraws $7 Billion Offer for Sun

I.B.M. withdrew its $7 billion bid for Sun Microsystems on Sunday, one day after Sun’s board balked at a reduced offer, according to three people close to the talks.

The deal’s collapse after weeks of negotiations raises questions about Sun’s next step, since the I.B.M. offer was far above the value of the Silicon Valley company’s shares when news of the I.B.M. offer first surfaced last month. Sun, an innovative pioneer in computer workstations, servers and Internet-era software, has struggled in recent years and spent months trying to secure a suitor.

With I.B.M. and others shying away from a deal, a bruised Sun could be forced to continue pursuing a solo business model whose prospects have been questioned by many analysts.

Had it bought Sun, I.B.M. would have become the dominant supplier of high-priced Unix servers and gained the rights to a number of popular business software franchises, including the Java technology used on many Web sites. The deal would have also helped I.B.M. compete against the hardware breadth of rival Hewlett-Packard and given it some momentum to combat Oracle’s ever-expanding business software empire. However, I.B.M. also faced the likelihood of antitrust reviews tied to the stronger positions in Unix servers and mainframe storage that it would have gained under the deal.

I.B.M. had a team of more than 100 lawyers conducting due-diligence research on potential problems in a purchase of Sun, ranging from those antitrust concerns to Sun’s contracts with employees and I.B.M. competitors.

After the legal review, I.B.M. shaved its offer Saturday from $9.55 a share, the proposal on the table late last week, to $9.40 a share, said one person familiar with the talks. The offer was presented to Sun’s board on Saturday, and the board balked. The Sun board did not reject the offer outright, but wanted certain guarantees that the I.B.M. side considered “onerous,” according to that person.

Sun then said it would no longer abide by its exclusive negotiating agreement with I.B.M., a second person familiar with the discussions said. On Sunday, I.B.M.’s board decided to withdraw the offer.

The breakdown in the talks, said the second person close to the negotiations, came over the shifting balance of price and conditions for the deal.

For example, I.B.M. scrutinized the “change of control” contracts with Sun executives, senior engineers and managers. I.B.M. felt that the payments to senior employees were higher and extended more broadly across the company than it had anticipated. I.B.M. pointed to the change of control contracts as one reason it was reducing its offer price.

Sun was most concerned about securing tighter provisions to restrict I.B.M.’s ability to walk away from the deal.

Whether the I.B.M. decision amounts to a negotiating tactic to get agreement on the final sticking points is unclear. Though the offer is off the table for now, the two sides could resume bargaining if Sun’s share price drops from its $8.49 close on Friday and major investors pressure the company to come to an agreement.

Since last year, Sun executives had been meeting with potential buyers. I.B.M. stepped up, seeing an opportunity to add to its large software business, acquire valuable researchers and consolidate the market for data center hardware.

In their talks, I.B.M. and Sun had a contract to deal with each other exclusively. Now Sun is free to pursue other suitors, including I.B.M. rivals like H.P. and Cisco Systems. Cisco recently entered the market for server computers.

The breakup of the deal, analysts say, is a blow to Sun’s prospects. “For I.B.M., given its size, this was never a transformational deal,” said A. M. Sacconaghi, an analyst for the investment research firm Sanford C. Bernstein. “But in Sun’s case, it’s an extremely material event.”

“This leaves Sun in a tough situation,” Mr. Sacconaghi added. “Sun was on a path to selling itself, and this will inevitably raise questions in customers’ minds, no matter what Sun says, about its commitment to a go-it-alone strategy.”

Sun’s management has come under repeated criticism for committing ever more deeply to a strategy that revolved around open-source software. Thus far, Sun has struggled to use the freely available software as a means of garnering related technology services contracts or hardware sales. The underlying strategy will probably face even more scrutiny now that customers and investors know that Sun had sought an exit through a deal with I.B.M.

“Sun is now sort of damaged goods,” Peter Falvey, the co-founder of Revolution Partners, a technology-focused investment bank, wrote in an e-mail message.

Late last year, Sun started to provide more detail than ever before about the sales of its various hardware and software businesses. Some people on Wall Street characterized the gesture as a type of advertisement to potential buyers, as Sun tried to highlight areas of growth. But the move may backfire later this month when Sun is scheduled to report its third-quarter results, which could reflect lackluster sales amid a broad slump in technology spending because of the recession.